Category: What is a Security?

Are Liquor Licenses Securities?

San Diego-based ANI Development LLC, its principal, Gina Champion-Cain, raised hundreds of millions of dollars from investors to make short-term, high-interest loans to parties seeking to acquire California alcohol licenses. The SEC alleges, the investment opportunities were shams and diverted directed significant amounts of investor funds to other uses.

Under California state law, liquor license applicants are required to escrow an amount equal to the license purchase price while their application remains pending with the State. Cain told investors that this regulatory requirement presented an investment opportunity.

She directed investors to deposit their money into specified escrow accounts maintained by ANI Development, and represented to them that their funds were being loaned to liquor license applicants at a high interest rate. That escrow agent allowed Cain to move the money around instead of keeping it safe in escrow.

Were those loans securities? If not, then its not securities fraud. The SEC addressed this is issue in the complaint using the Howey test.

60. As directed by defendants, investors’ funds were pooled in a common escrow account, which defendants claimed was being used to fund the transfer of California state liquor licenses.
61. Whether investors would profit from their investment was dependent on the success of defendants’ represented liquor license funding program.
62. Cain and ANI Development’s efforts in identifying liquor license escrow participants who were appropriate for investment, executing the loans to those entities, and collecting the purported interest payments from those participants, were critical to the enterprise’s success, as investors were not allowed to play an active role in managing ANI Development’s investment decisions under the claimed liquor license funding program.

Sounds like it passes the test because Cain pooled money into the escrow accounts instead of keeping them separate.

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Is a Note from a Real Estate Wholesale a Security?

I saw the recent case against Landon M. Smith for operating a real estate offering fraud and Ponzi scheme and jumped in to see if I could learn anything from the case.

According to the SEC complaint, Smith held himself out as a “property wholesaler” who could earn significant returns on any funds invested with him for purported property deals.

Smith explained that a property wholesaler is a person who identifies property and then agrees to buy property for a certain price, signs a real estate purchase contract with the property owner, and pays the property owner an earnest money deposit to hold the property under contract until the sale can close. The wholesaler then finds a third-party buyer who is willing to pay more for the property than the wholesaler agreed to pay in the purchase contract

That’s not a real thing. There is no pool of real estate owners willing to sell for wholesale (less than market) or sellers willing to pay more than market. He faked the real estate contracts he was showing to his “investors.”

Needless to say he was taking money from people. They forked it over with his promise of a 100% return when he flipped the property.

Smith was offering his “investors” unsecured promissory notes. Are those promissory notes securities?

The Securities and Exchange Commission thinks so.

  1. Investors provided Smith with money to purchase promissory notes with the potential to earn returns of up to 100% on their investment.
  2. Smith sold the promissory notes to a wide distribution of unsophisticated investors.
  3. Smith represented the opportunity as a short-term investment.
  4. The promissory notes were all unsecured and uninsured.
  5. Smith pooled investor funds in a common bank account.
  6. Investors expected profitability from the wholesaling efforts of Smith.

I assume they are using the Howey test of investment contract, “investment of money” in “a common enterprise” with the “expectation of profits from the effort of others”. Or may just be using the term “note” from the definition of security.  

Statements 2, 3, and 4 seem irrelevant to the argument that the “notes” are securities. Statement 5 seems to indicate that there was a common enterprise. But the mixing in the bank account may just be a byproduct of the Ponzi scheme. Smith pooled the money to pay back earlier investors.

It’s not clear if multiple “investors” were expecting their money to mixed in with other “investors” to fund the investment or whether each was expected to be freestanding.

It’s a relatively weak argument that the notes are securities. But Smith settled with the SEC so the argument doesn’t need to stand up to scrutiny.

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ZuckBucks and Securities

Facebook is looking to get into banking. Or Cryptocurrency. Whatever you call it, Facebook is looking to launch a global currency: Libra.

The big problem is mashing together the current lack of trust in Facebook with the hype of blockchain technology. As a result, Libra talks little about Facebook and lots about blockchain.

It’s not clear that Libra is using blockchain like other cryptocurrencies and it’s not clear that it can be used outside of Facebook.

Bitcoin and other cryptocurrencies have failed as currency because so few merchants will take it as payment. Facebook is potentially allowing the widespread use of Libra by making it the payment of choice through the Facebook platform.

Unlike Bitcoin, Libra is intended to be stable in price. It’s value will be pinned to an underlying portfolio of bank deposits and government securities. The focus is spending Libra, not investing in Libra.

As for the investment part, the underlying Libra asset returns will be used to fund investments in the platform and any remaining returns would be paid as dividends to the early investors.

The details are a bit sparse, but it sounds like Libra would not be a security to the everyday purchaser, but could be a security to the early investors.

Those early investors are a consortium of participants that will provide the governance and manage the currency. They will also need to pony up at least $10 million in initial funding.

I assume that Facebook and rest of the Libra Consortium are going make sure Libra does not trip over securities laws.

The big problem is going to be money laundering, sanctions limits, and cross-country transfers. Libra is being touted as panacea for the unbanked. However, the unbanked include the criminal elements who do not have access to banking system. I suspect this will be the bigger challenge of Libra.

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Can a Real Estate Lot Be a Security?

Of course the lawyerly answer is: “maybe.”

Ronald Duane Dunham challenged his criminal conviction for securities fraud, arguing that the Cherokee Village lots he sold did not qualify as securities under the California Corporation Code.

Mr. Dunham got in this position by persuading a number of elderly victims to invest over a million dollars with him, ostensibly to purchase undeveloped “lots” of land in Cherokee Village, Arkansas, and/or support Dunham’s real estate development efforts there between 2004 and 2007. The lots were sold to the victims at an inflated price and marketed at times in conjunction with Ed McMahon.

The crash of 2008 happened and the victims sued to get their money back. The victims lawyer after reviewing documents from discovery thought Dunham’s actions were bad enough to warrant a criminal investigation and the District Attorney agreed. Dunham was eventually convicted.

Keith Paul Bishop highlighted this case last week: Court Rules Lot Sales Were Sales Of Securities.

” U.S. District Court Judge Gonzalo P. Curiel denied Dunham’s petition.   Citing SEC v. Schooler, 905 F.3d 1107 (9th Circ. 2018), Judge Curiel reasoned that a reasonable jury could have concluded that lots sold by Dunham were not independent real estate transactions but the sale of securities “

Mere “lots” as securities? Usually, these cases involve some form of management company, investment fund or partnership. The Denial of Habeus Corpus even cites the Schooler case where a general partnership in real estate was considered a security.

Dunham’s trial court jury had found that lots represented the victims’ “shares in [the] enterprise.”

None of the California victims had any ability to develop homes in Arkansas, and they expected “Dunham and company” to sell their lots for them. The victims were relying on Dunham to bring professional management, homebuilding, and financing experience to the project. They had no desire to live in Arkansas themselves, except possibly Marilyne who would consider it after first realizing a profit. The victims sought a return on their investment, and a profitable retirement community required a certain volume of lots to succeed. On a whole, and considering the purpose of our securities laws to protect the public from fraudulent investment schemes, the Cherokee Village lot transactions qualified as investment contracts.

Page 56 of the Writ of Habeus Corpus

The federal court agreed. There didn’t seem to be any formal agreement for the Dunham to manage the investments. But, all of the victims testified they
were told they were purchasing lots in order to be part of and profit from a future retirement development in the area. Dunham held events where he presented plans for the development and marketing campaigns after the development of the area. There was some evidence that Dunham himself thought there was a common enterprise.

This is a big extension of the Howey test to real estate. The sale of dirt in a remote area, coupled with a seller’s promises are enough to bring the transaction into the definition of “investment contract.”

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Affiliate Transactions as a Ponzi Scheme

Actions by the Securities and Exchange Commission against real estate companies will catch my attention. A recent complaint against Robert Morgan and his affiliated real estate funds did just that.

The SEC complaint is just charges, so we don’t know if the statements are true or what Morgan’s response will be. I’m just using it as a learning tool.

The main charge against Morgan is a criminal complaint for mortgage fraud. In a Department of Justice press release:

The defendants provided false information to financial institutions and government sponsored enterprises overstating the incomes of properties owned by Morgan Management or certain principals of Morgan Management. The false information induced financial institutions to issue loans: (1) for greater values than the financial institutions would have authorized had they been provided with truthful information; and (2) that the financial institutions would not have issued at the time of issuance had they been provided with truthful information.

The SEC grabbed a piece of the action when it was discovered that Morgan has raised four private funds from investors to finance Morgan properties. The funds, managed by Morgan, made what look like mezzanine loans to the properties owned by Morgan.

See if you if you can spot the conflict? Yes it’s obvious.

According to the complaint, Morgan did not treat these as third-party loans in terms of documentation or valuation of the underlying assets. Morgan also used funds to pay off loans that were maturing and owed to other funds.

Lots of conflicts for sure. According to the complaint, the offering materials stated that the loans from the funds would be going to affiliates managed by the funds’ manager. According to the complaint, one fund’s loan to a Morgan affiliate was often used to fund the repayment of another fund’s loan. The SEC labels these pay-off as “Ponzi scheme-like payments.”

The SEC brought its charges for violating the anti-fraud provisions of the Securities Act and Exchange Act.

Numerous affiliate transactions like those in the Morgan empire are full of conflicts and issues. It can be done, with lots of controls and documentation in place. The SEC complaint makes it sound like those were not in place.

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Howey Test – Framework for “Investment Contract” Analysis of Digital Assets

To show the markets that the Securities and Exchange Commission is not just about slapping around wrong-doers, but also trying to help people navigate the securities laws, the SEC’s FinHub published a framework for analyzing whether a digital asset is a security.

The framework is not intended to be an exhaustive overview of the law; rather, it is a tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset.

Did anyone find it strange that the “framework” document had not statement of the author or publisher? There is not even an SEC symbol.

That should be a warning that you can’t rely on it. It’s not official guidance. It’s not a no-action letter.

It is a comprehensive look at the Howey test in the lens of cryptocurrency. The Supreme Court’s decision in SEC v. W.J. Howey Co. found that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.  If it’s an “investment contract,” it’s a security and subject to securities laws.

The framework quickly jumps over the first two prongs of the Howey test:
the “investment of money” and “a common enterprise.” That’s true in most of the “What is a Security?” cases. 

The framework focuses on the “expectation of profits from the effort of others” prong of the Howey test. The Framework splits that into two parts.

Generally, if you make an investment you expect to make a profit. Otherwise it’s just a purchase for use. I bought a cup of coffee this morning. I had not expectation of profit. I had an expectation of getting coffee. I bought it with a stored value card from Starbucks. It’s not an investment. Those could have been Starbucks coins.

You can see an obvious problem with ICOs that talk about how much the coins are going to increase in value. That injects an expectation of profit. The framework lays out a long list of characteristics that make sit likely the SEC will see that there is an expectation of profits.

“Lambo, Lambo, Lambo” was not specifically on the list. They took a more demure “able to earn a return on their purchase.”

The framework inquiry into whether a digital coin purchaser is relying on the “efforts of others” focuses on two key issues:

  • Does the purchaser reasonably expect to rely on the efforts of an active participant in running the underlying platform?
  • Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?

If there is a key person responsible for the development of the platform and making the decisions, that makes it look an investment.

To put this framework into play the SEC also announced a no-action letter for the Turnkey Jet token sale (TKJ) and found that it would not recommend enforcement because it was not a securities offering.

In reaching this position, we particularly note that:

1. TKJ will not use any funds from Token sales to develop the TKJ Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold;
 
2. the Tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold;
 
3. TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform;
 
4. TKJ will sell Tokens at a price of one USD per Token throughout the life of the Program, and each Token will represent a TKJ obligation to supply air charter services at a value of one USD per Token;
 
5. If TKJ offers to repurchase Tokens, it will only do so at a discount to the face value of the Tokens (one USD per Token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the Tokens; and
 
6. The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.

The Turnkey Jet token is a stored value card saved on the blockchain instead of a central account. That’s closer to buying a cup coffee than it is to investing.

Of course, the framework is just the SEC’s view on securities law question under federal law. There are also state law analyses that need to be done.

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Nevermind, That ICO Was a Securities Offering

Apparently, the blockchain makes everything cooler as a way to invest. Even securities laws shouldn’t get in the way. Reginald Buddy Ringgold, III thought he had escaped from the grasp of the SEC when a court refued to issue a preliminary injunction against his Blockvest ICO. The court changed its mind and slapped an injunction in place.

Back in October, the SEC brought charges against Mr. Ringgold, alleging that that they were planning to raise funds through an initial coin offering for financial products that would generate double-digit returns based on misrepresentations about the firm’s regulatory status. He used the SEC seal without permission and falsely claimed that their crypto fund was “licensed and regulated.” He also promoted the ICO with a fake regulatory agency he created, the “Blockchain Exchange Commission,” with a seal similar to the SEC seal and the same address as SEC headquarters. (It was that last bit that caught my attention.)

In looking at whether the Blockvest ICO was a securities offering, the court said no to the SEC because Mr. Ringgold said that the ICO was just a test platform and people were not really investing money. The court found that moving enough to find it not a securities offering.

In its new strategy, the SEC targeted the website advertising of the ICO. An offer of unregistered securities can be enough.

Section 17(a) applies to the “offer” or “sale” of securities. 15 U.S.C. § 77q. A violation of Section 17(a) does not require a completed sale of securities. See SEC v. American Commodity Exch., 546 F.2d 1361, 1366 (10th Cir. 1976) (“actual sales [are] not essential” for liability to attach under § 17(a) and § 10(b)); S.E.C. v. Tambone, 550 F.3d 106, 122 (1st Cir. 2008) (noting that “because section 17(a) applies to both sales and offers to sell securities, the SEC need not base its claim of liability on any completed transaction at all”).

Under securities law and caselaw, the definition of “offer” is broad. There is no requirement that performance must be possible or that the issuer must be able to legally bind a purchaser. That “Buy Now” button on the BlockVest website, along with the whitepaper and other descriptions were enough for the court to conclude that it was an offering.

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A Court Rules that an ICO was not a Securities Offering

Last month, I wrote about the complaint filed by Securities and Exchange Commission against Reginald Ringgold and his Blockvest initial coin offering. One of the Blockvest’s marketing ploys was to note its membership in the Blockchain Exchange Commission.

The SEC managed to obtain an emergency court order to halt a planned initial coin offering of Blockvest, which falsely claimed that it was approved by the SEC. The order also halts ongoing pre-ICO sales.

After a hearing and Mr. Ringgold’s presentation of his side of the story, the court decided to deny the SEC’s motion for a preliminary injunction. The court found that there are disputed facts about the nature of Blockvest’s status that makes it unclear if the tokens were securities.

The main defense of Mr. Ringgold is that Blockvest was only in the test stage. The 32 “purchasers” of the Blockvest tokens were test users. It was not clear that the test users had an expectation of profit or that their purchase were actually at risk while Blockvest was testing.  The SEC and Mr. Ringgold had different stories of what documents were made available to these testers that induced them to buy the Blockvest tokens.

The “Buy Now” button on the Blockvest website didn’t work.

My reading of the decision is that Blockvest was not yet an ICO so there was no securities offering. The SEC action has stopped it. The Court found that it’s unlikely that Mr. Ringgold will make the offering.

While there is evidence that Ringgold made misrepresentations shortly after the complaint was filed and prior to having retained counsel, Ringgold, with counsel, now asserts he will not pursue the ICO and will provide SEC’s counsel with 30 days’ notice in the event they decide to proceed. By agreeing to stop any pursuit of the ICO, Plaintiff does not oppose the preliminary injunction concerning compliance with federal securities laws. Therefore, Plaintiff has not demonstrated a reasonable likelihood that the wrong will be repeated.

It looks like it’s a win for both sided. The SEC stopped Blockvest before it could take money from the public and Mr. Ringgold managed to avoid immediate SEC action.

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Is Stock in a Mutual Water Company a Security?

The Securities and Exchange Commission says “no.”

My first question is what is a mutual water water company? From my view here in New England water comes from the municipality or your own well. California is big and creating whole new communities.

In this case, the Tesoro Viejo Master Mutual Water Company is being formed to supply water to a new community in Madera County, California that will have over 5,000 residential units and 3 million square feet of commercial and retail space. The Water Company will issue stock to owners of lots in the Water Company service area. The shares are appurtenant to the land and can only be transferred with the land. The shareholders still have to pay for the water they use to the Water Company. The Water Company is responsible for maintaining the water infrastructure in the service area.

The Water Company is organized under California’s General Corporation Law.  It is issuing shares of common stock.

Under Section 2(a)(1) of the Securities Act the term “security” means any “note, stock…”

So, it’s clearly a security?

No. The request letter authored by Keith Paul Bishop takes us on a great stroll on the analysis of “what is a security?”

In United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), the United States Supreme Court found that not all stock is a security. In that case, it looked at shares issued and sold as part of housing coop in New York. The Court came up with five characteristics of a stock:

  1. Right to receive dividends
  2. Negotiability
  3. Ability to be pledged
  4. Voting rights
  5. Ability to appreciate in value.

The Court says you should look at the economic realities of the transaction rather than just the mere form.

In the argument for the Water Company, the substance is the sale of real estate, not the sale of securities. The Water Company will not pay dividends and there is will be no market for the shares so there can’t be any appreciation in value separate from the land. The shares can’t transferred without the sale of land and can’t be pledged separately from the land. The ability to vote is also tied to land ownership.

Attorney Bishop then goes on to walk through the “investment contract” analysis under Howey.

There is an investment of money. There is probably exists since there will be aboard governing the Water Company.

But there is no expectation of profit from the Water Company. The purchasers are buying the shares to obtain water services and they still have to pay for the services. There will be no distributions of profits. There may be some increase in value, but no way to realize it. The increase in value can’t be separate from the increase in value of the real estate.

The Securities and Exchange Commission went along with these arguments and granted no-action relief.

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The One with the New Commuter Rail Station

Todd Hitt wanted to be big-time, but his lies have landed him in handcuffs. He claimed that the firm he founded, Kiddar Capital, had over $1.4 billion in assets under management, offices in Falls Church, Houston, Palm Springs, and London, and was put $6 million of the firm’s money into developing a Herndon, Virginia building adjacent to a future stop on the Silver Line of the D.C. Metro.

According to a complaint by the Securities and Exchange Commission and the Department of Justice, none of that was true.

Mr. Hitt solicited investors into the real estate deal, with Kiddar putting in $6 million, investors putting in $6 million and the rest of the capital from a $24 million bank loan. Mr. Hitt was good at the fundraising because he raised almost $10 million, some of that coming after the offering closed. The capital needs of the project were reduced by seller credits, requiring less than $9 million in equity after the bank loan. The complaints allege that Hitt transferred the extra cash for personal use or other projects and never put any of Kiddar’s own capital into the commuter rail station project.

The SEC is involved so this must mean securities fraud. It’s clearly a real estate transaction. One question is whether Kiddar Capital was selling interests in the real estate that could be considered securities.

According to the SEC complaint, the offering memorandum stated that it was “a private offering exempt from the registration requirements of the Securities Act of 1933.” The SEC also pleads that “investors relied entirely on, and expected profits solely from, the efforts of Defendants to manage their investments” in Class A membership interests in the real estate purchaser. That’s the brief description of the Howey test.

How did Mr. Hitt get caught?

According to the criminal action, two employees of Kiddar Capital contacted the FBI about Hitt, alleging that he was stealing investor funds or commingling investor funds. Each thought things were strange and had trouble tying together financial claims.

One of those whistleblowers tried to tried to reconcile the representation that Kiddar Capital had $1.4 billion in assets. That employee only came up with $27 million. The other employee tried to find the other Kiddar Capital offices and couldn’t.

For me, the key thing was the statement that Mr. Hitt was spending lavishly, but had liquidity trouble. The example in the criminal complaint is that Mr. Hitt employed a personal driver, but had trouble funding payroll at times. A sure way to lose employees is to not pay them.

It’s easier to be whistleblower and risk losing your job when your not getting paid anyhow.

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